Till Debt Do Us Part

The European marriage between its peripheral and core countries shows all the signs of the parties having irreconcilable differences.

Since the wake of the Greek economic crisis early last year, there have been ever-growing signs of strain in the rocky marriage between Europe’s so-called peripheral countries and those at its core. Events now playing out in Dublin and Berlin suggest that the European marriage is becoming irreconcilable. This hardly bodes well for the long-run survival of the euro in its present form.

Last year marked the start of the European periphery’s humiliating loss of economic sovereignty to the International Monetary Fund (IMF) and to the European core countries. In May 2010, in the midst of a major government funding crisis, Greece had little alternative but to go cap in hand to the IMF and the European Union for emergency funding. In return for that financial support, Greece was lectured about its profligate ways and forced to sign a three-year IMF-monitored economic adjustment program. The IMF program involved the most stringent measures of budget austerity and painful structural economic reform. As was to be expected, budget stringency within the straitjacket of euro membership has plunged Greece into its deepest postwar economic recession, while economic indicators suggest that Greece’s economic recession will deepen further in 2011 under the weight of additional budget restraint.

Over the past two years, fiscal austerity has caused a 12 percent contraction in the Irish economy and an increase in the unemployment rate to nearly 14 percent.

No sooner had European policy makers finished reassuring markets that Greece’s economic woes were sui generis and that its problems would be ring-fenced, than Ireland came under the severest of financial market pressure, towards the end of 2010. A major source of that pressure was the market’s realization that the Irish government’s blanket guarantees of its banking system’s liabilities, in the wake of the bursting of the Irish housing market bubble, had effectively rendered the Irish government insolvent. As was the way with Greece, Ireland also became shut out from the international capital market and was forced into the arms of the IMF-EU moneymen for a multi-year financial bailout.

A key condition of the IMF-EU bailout was Ireland’s commitment to cut its budget deficit by as much as 10 percentage points of gross domestic product over a three-year period. Never mind that pursuing hair-shirt fiscal austerity of that magnitude while stuck in the euro will be all the more painful for a country in Ireland’s particular situation. Over the past two years, fiscal austerity has already caused a 12 percent contraction in the Irish economy and an increase in the unemployment rate to nearly 14 percent.

As a prelude to what is likely to occur later in Greece, Portugal, and Spain as fiscal austerity really begins to bite, the Irish IMF adjustment program has produced a veritable backlash of political anger against Ireland’s foreign taskmasters. Ireland’s Fianna Fail government has been a conspicuous victim of the crisis. The Irish public is particularly incensed about Ireland’s loss of economic sovereignty, epitomized by the belt-tightening measures imposed from abroad and the European Central Bank’s strong opposition to any notion of Ireland restructuring unsecured senior bank bond debt.

The Irish IMF adjustment program has produced a veritable backlash of political anger against Ireland’s foreign taskmasters.

Ominously, in the run-up to the general Irish election now scheduled for February 25, the two major Irish opposition parties are proposing that the election be considered a public referendum on the IMF program. In particular, they both insist that the interest rates being charged on IMF-EU borrowing be reduced to more affordable levels, and that senior external bondholders of the Irish banks should bear at least part of the burden of Ireland’s adjustment program.

While Irish politicians are suggesting to their domestic electorates that ways must be found to ease pressure on the Irish economy and that the burden of adjustment must be shared more equitably with foreign bondholders, German Chancellor Angela Merkel is trying to move Europe in the opposite direction. She proposes that any enlargement of Europe’s bailout facility must be accompanied by even stronger commitments in the European periphery to budget austerity. She also proposes that there must be greater economic policy coordination across European countries and that this coordination must be along German lines. Sensitive areas where she would like to see greater policy coordination include increasing the retirement age, abolishing wage indexation, harmonizing taxes across the eurozone, and setting strict limits on the ability of countries to increase debt.

Some marriages can be salvaged by patient outside counseling. Where there are irreconcilable differences, however, outside counseling can do little. Sadly, the European marriage between its periphery and its core is showing all the signs of the parties having irreconcilable differences. And as the recessions in the periphery deepen under the weight of IMF-imposed austerity, these differences will eventually lead to some sort of separation of the European periphery from its core.